he Germans are
calling it Zeitwende,
or a turning point in history. As happens
with wars, the armed conflict now taking place in Europe promises to
transform long-established practices, relationships, and attitudes for a
long time to come. The most immediate impact has been a change in the
defensive stance of Western Europe, almost, literally, overnight. The
assumption that deepening trade relations among states would mitigate
against adventurism has been proven false, now that a large and
militarily-powerful neighbor to the East is no longer reliable and
predictable under its current leadership. As a result, NATO countries
will soon be spending much more heavily on military hardware and
readiness on an ongoing basis. For Germany in particular, whose post-war
history has been pacifistic, this represents a radical departure.
Reunited during the collapse of the Soviet empire, Germany is now
re-arming because of Russia’s attempt to expand its dominion anew, a
step once held to be unthinkable, especially among the German people.
Globally, the
Zeitwende
may have even more profound implications in the long run. The
international economic sphere has been disrupted, most directly in
Europe. In recent decades, the Continent has become heavily reliant for
its energy needs on Russia, the world’s third-largest producer of
hydrocarbons — coal, petroleum, and natural gas. Russian supplies 40% of
Europe’s gas needs (50% of Germany’s), and 25% of its petroleum
requirements (33% for Germany). 50% of the coal burned in Germany comes
from Russia. Consumers and industry are facing skyrocketing prices for
these commodities as well as for electricity, and hydrocarbon- or
energy-intensive businesses such as fertilizer and aluminum have had to
curtail or shut down production. Attempts to convert European economies
to green energy sources have not proceeded quickly and far enough to
reduce the dependency on hydrocarbons, hence the continuing reliance on
Russia and the dilemma currently facing Western Europe. Because
hydrocarbons trade in international markets, the reduction in Russian
energy shipments due to blockades, and the possible cut-off of its
exports to Europe, have pushed up prices everywhere. (Note: U.S.
petroleum and gasoline prices came close to hitting new highs this
year.) This comes on top of a tight market resulting from resurgent
demand and a lack of investment; energy prices had already risen
significantly before the Ukrainian war began.
The war has also impacted trading in other
important commodities. Both Ukraine and Russia are big producers of
grains, together accounting for one-third of the global wheat trade.
(Ukraine is known as the “breadbasket” of Europe.) Already, poorer
nations are suffering from food shortages as disruptions of supply drive
up prices. Russia is the second-largest producer of aluminum (the price
of which has recently hit records), and Russia and Ukraine together
dominate the supply of neon, a gas critical in the manufacture of the
silicon chips used in computing equipment.
Some observers are now maintaining that the
decades-long trend of “globalization” is coming to an end. Due to the
impact of the Covid pandemic and national responses to that health
crisis (such as China’s closure of port facilities and lockdowns of
entire cities), industrial nations were already re-assessing their
supply chains and sourcing of key inputs such as the rare earth elements
used in a multitude of technological applications. Concentration had
also raised alarm bells; the technology industry, for example, is
reliant on Taiwan for 50-90% of certain semiconductor chip products.
Russia’s hostility towards neighboring Ukraine has reminded people that
China nurses similar grievances with respect to the island it claims as
a “province.” Even low-tech industries such as furniture have supply
chains stretching to China and Viet Nam that caused product-availability
problems when the pandemic interfered with ocean shipping. Ukraine
itself is the source of wiring assemblies used in truck production,
causing at least one German manufacturer to shut down assemblies since
hostilities began. The Ukraine conflict, and Russia’s apparent use of
its market position in certain commodities as a coercive tool, have
accelerated the re-evaluation of the globalized industrial regime. A
re-ordering of world production and trading patterns may be underway
before our very eyes.
We are skeptical of a permanent renunciation of
global integration
—
after all, it is a process that arguably has been
underway for millennia, though with many interruptions and major
setbacks
—
but even a relatively short-term halt could have unaccustomed
consequences. Partly due to global sourcing and supply chains, American
industry has been running historically high profit margins: 10-11%
versus 5-6% in the past (margins that are reflected in elevated stock
valuations). Consumers have also enjoyed lower prices on imported goods.
The downside has been a gutting of U.S. industrial capacity, and either
a shift to lower wages for a significant part of the American workforce,
or little or no wage growth, as well-paying manufacturing employment
disappeared, forcing workers into typically minimum wage service sector
jobs. A “reshoring” of manufacturing could very well benefit U.S.
workers, but at the cost of higher prices in stores. We would also add
that some re-thinking of offshoring had been occurring “naturally” as
production costs in foreign manufacturing centers have increased in
recent years (higher wages in China, for example), offsetting some of
the cost advantage of outsourcing production abroad.
Reactions to the quarter’s events in the
financial markets have been diverse. Not surprisingly, commodities have
seen intense action, but stock market behavior has been, overall,
remarkably muted. There was an initial sharp reaction to the invasion of
Ukraine on February 24: in the U.S. the S&P 500 fell 15% from its
January peak, and the NASDAQ dropped over 20%. Some of those declines
occurred during the buildup to the invasion as markets began to discount
the risk of conflict. Nevertheless, the indexes have been recovering in
fits and starts. The benchmark S&P 500 index finished March down 4.6%
year-to-date; the Nasdaq fell about 9% over the period, both well above
their low points, but still the worst quarter in two years. Wars
generally have a mixed effect on the stock market (at least in the U.S.
where conflict has not taken place on home soil for a very long time).
Fear and uncertainty take their toll, but spending boosts and increased
industrial activity tend to be favorable for profits and stocks. Bonds,
on the other hand, have fallen, and interest rates have risen in
response to higher reported inflation both before and after the Ukraine
invasion, with one index of U.S. treasury securities dropping 5.6% in
the first quarter, a record decline. Even the normally staid market for
municipal bonds suffered its worst quarter since the 1980s, falling 6%.
Financial historians
looking back at the beginning of the third decade of this century will
undoubtedly see a period characterized by almost unimaginable amounts of
liquidity — financial firepower
—
looking for a home. Fed by central bank
actions to counter the impacts of health crises and economic shocks, as
well as a booming economy, and, as we now know, a sizable dollop of cash
from less savory sources, money flowed into every conceivable asset:
stocks, bonds, real estate, superyachts, sports teams, and more.
Multiple bids for homes at above asking prices and same-day closings
were a sign of the times. Financial sector operations and products
sprouted like weeds as they fed on the cash bounty, and managed
funds
—
such as “private equity” and hedge funds
—
attracted capital and
grew to the point of bloatedness, intent on buying
something
—
anything
—
that would produce a yield. In other words, this
period will be looked back on as a great time to be a
seller of
assets.
The ultimate outcome
of this frenetic activity may well be another
Zeitwende.
In the forty-year period from the early 1980s-2020, annual inflation in
the U.S. gradually declined from about 15% to roughly 1%, following an
undulating pattern with lower peaks along the way. Accompanying this
deflationary trend was a bull market in bonds that took interest rates
from the 15-20% range down to zero (and in the case of some foreign
sovereign bonds, below
zero). Falling rates were a natural consequence of declining inflation
because low inflation means that a fixed income stream is more
valuable
—
since purchasing power will not be eroded as quickly
—
going
forward.
Some observers believe the trend has reversed
and that we are now entering an era of higher inflation and rising
interest rates as factors which had held down inflation —
globalization,
the entry of new populations into the global work force, relatively
stable energy prices —
become a thing of the past. While the evidence is
still scant, it could support this view. Inflation started to rise in
the spring of 2021 and reached an annual rate of 7% late in the year,
the highest since 1982. The jump in inflation caused a great deal of
consternation on Wall Street and in the financial press, which feared
the Federal Reserve had fallen behind in its inflation-fighting duties.
Market interest rates rose to multi-year highs as well, as would be
expected given the increasing price pressure. Having hit a low of around
0.5% in 2020, and at just 1% as recently as last summer, the U.S.
ten-year treasury note reached 2.5% in the first quarter. Astonishingly,
the two-year treasury note’s yield rose almost one percentage point just
in the month of March to about 2.4%. Remember that a rise in bond yields
means that prices for the fixed-income securities have fallen.
We have been warning about the bond market for
years, arguing that the returns being offered were not worth the risks
assumed. Paying top dollar for a ten-year bond yielding 0.5% means that
a miniscule price decline would wipe out any yield advantage over
shorter term investments, and, were it to be sold, result in a capital
loss. If held, the buyer would eventually get their money back at the
end of ten years, but would still have only a paltry 0.5% return to show
for it. As noted above, fixed-income buyers have already suffered
significant price declines with the rise in rates. Since those higher
rates are still quite low historically, it is conceivable that losses
could mount even further.
No one can say with
confidence whether a new long-term interest rate cycle mirroring the one
most market participants have known is correct; only time will tell. Our
remit is to protect capital, whatever the future brings. Along those
lines, looking at the two-year treasury note presents an intriguing
picture. At 2.5% its yield remains far below both its 30-year peak of
nearly 10%, and long-term average in the 4-5% range. Nevertheless, it is
far more interesting as a potential investment than the
0.15% it
offered only a year ago, or short-term bills currently yielding 1% or
less. Regardless of where rates may be headed, a case could be made for
tying up some capital for two years with no credit and little price risk
for a yield that is a multiple of that currently obtainable from money
market funds, especially in an environment as volatile and uncertain as
the one we now face. Far be it for us to express excitement over a 2.5%
return, but at long last investors may have an opportunity to get paid
to park funds in a safe place until something better comes along.
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